Book Review: The Fed And Lehman Brothers by Laurence Ball

ben_bernanke

In a new book just out to this month, The Fed And Lehman Brothers, economist Laurence M. Ball re-examines the evidence of the choices facing the managers of the 2008 financial crisis. In particular he looks at a crucial choice – to let the storied Wall Street firm Lehman Brothers fail in bankruptcy rather than offer taxpayer support for a bailout.

His conclusion: the Federal Reserve, US Treasury, and New York Fed made a grave unforced error in allowing Lehman Brothers to declare a messy bankruptcy – still the largest US corporate bankruptcy of all time – in the process adding destructive force to the financial tsunami already enveloping the economy and financial markets in September 2008. And they disingenuously described the reasons for their decision.

The main managers of the 2008 financial crisis, Treasury Secretary Hank Paulson, New York Federal Reserve Bank President Tim Geithner, and Federal Reserve Chairman Ben Bernanke all claimed in official testimony and their subsequent memoirs that Lehman Brothers was “insolvent” at the time of the bankruptcy. One of the conditions of Fed lending is that it cannot lend money to insolvent institutions, or banks with insufficient collateral to pledge for a new loan.

It is undeniable that Lehman faced a liquidity crisis in September 2008 – the inability to pay back everyone it owed money to, if everyone wanted their money back right away. That’s a classic problem facing any bank in which depositors demand immediate return of their deposits. The dispute Ball addresses is whether Lehman had enough assets in the medium-to-long run that would have covered what it owed so that a fresh loan from the Fed could have averted bankruptcy.

In household terms, we can imagine a well-off person with a valuable house and car worth a million dollars, $25,000 cash in the bank, and who owes $750,000 in a combination of a personal loan, mortgage and car loan. If a lender suddenly demands a $100,000 personal loan be paid back immediately, we would say that person has a liquidity problem but is not insolvent. Given enough time, the person could likely solve the problem, through a sale of the car and house. Even easier than a fire sale of the car and house, a fresh loan against the home equity would ease the situation. Bankruptcy is far from inevitable.

In the case of Lehman, Ball argues, the Federal Reserve had created a program earlier in 2008 that could have provided that fresh loan.

Through reviewing pre-bankruptcy financial disclosures, reports of the bankruptcy managers, and independent analyses of firms that considered purchasing Lehman but declined, Ball details the amount of assets Lehman had the week before it declared bankruptcy.

Hank_PaulsonHe conservatively estimates the assets available to pledge as collateral for a new loan from the Fed totaled $118 billion. Lehman’s ultimate need for funds, again conservatively estimated, probably reached $84 billion. In that difference, in the amount of available assets above Lehman’s borrowing needs, Ball makes the case that this was a liquidity problem, not an insolvency problem.

$84 billion, of course, is quite a bit of money. But considering that the Fed committed $123 billion to AIG and $107 billion to Morgan Stanley that same month, it wasn’t out of the range of what the Fed was otherwise and ultimately willing to commit to dampen the financial tsunami.

The managers of the crisis have claimed, to this day, the opposite. They argue that Lehman was insolvent, and any new loan from the Fed would put taxpayer money at risk of loss.

This may all seem like ancient history, but it’s still relevant today. The Fed raised rates a few weeks ago and plans a few more rate hikes the year, unwinding policies in place since the crisis. Meanwhile, we’re still trying to figure out what the right lessons are from 2008. We still do not have an agreement on the correct solution to Too Big To Fail financial institutions when they get in trouble and face a loss of confidence, essentially a “run on the bank.”

ben_bernankeDo we essentially nationalize them, as we did to mortgage giants Fannie Mae and Freddie Mac? Do we take an 80 percent government ownership, then slowly sell the pieces back to the public markets as they recover, as we did with insurance giant AIG? Do we guaranty portions of their bad debt portfolios and force a shotgun marriage among investment banks, as we did when JP Morgan Chase bought Bear Stearns and Bank of America bought Merrill Lynch? Or do we convert them to commercial banks from one day the next, and inject $20 billion of capital to signal public support, as we did with Goldman Sachs and Morgan Stanley?
The managers of the crisis did all these different things, with wildly differing outcomes for firms, employees, executives, shareholders, bondholders, and taxpayers.

The managers tried everything. The messiest, least controlled, and most destructive was the Lehman bankruptcy. Ball’s big question – did it have to happen? – is a counterfactual exercise that informs future choices. He further concludes, despite all the testimony of the crisis managers, that Treasury Secretary Paulson essentially made the call to let Lehman fail.
Paulson’s concern was to avoid the label “Mr. Bailout” in 2008, so he wanted to signal with the bankruptcy that sometimes firms did fail and that the government wouldn’t always be there. Ironically the bankruptcy was so disruptive that Paulson and the rest had to double-down, triple-down, and then quadruple-down on further bailouts. Clearly they did not anticipate the depth of the mess of Lehman’s bankruptcy filing.

The_Fed_And_Lehman_brothersHaving said that, it doesn’t mean I think that Paulson, Geithner and Bernanke blew it in the management of the 2008 crisis. My overwhelming thought, ten years later, is how well they responded to unprecedented and unpredictable events. We are incredibly fortunate those particularly competent people held those positions at that particularly crucial time. They made one big mistake with Lehman, and they kind of fudged their reasons for it, but overall managed throughout the fog-of-war of the 2008 crisis admirably.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Book Review: Too Big To Fail by Andrew Ross Sorkin

Book Review: Diary Of A Very Bad Year by Anonymous Hedge Fund Manager

 

 

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Book Review: The ChickenShit Club by Jesse Eisinger

Editor’s Note: I did a podcast with Jesse Eisinger for the finance website Make Change, in which we discuss his book in further detail. I recommend listening to it here!

Nine years after the Great Recession mortgage bond crisis of 2008, no executives with any seniority on Wall Street faced criminal consequences. Although a few suffered civil penalties like fines, the lack of jail time left many asking, why?

chicken_shit_clubSeptember 2017 marks the ninth anniversary of the most explosive month of the Great Recession. Over one dramatic weekend nine years ago, legendary Wall Street firm Lehman Brothers declared bankruptcy, brokerage giant Merrill Lynch threw itself desperately into the arms of Bank of America, and insurance conglomerate AIG became an 80% ward of the federal government. That very bad weekend in mid-September followed hot on the heels of the previous week’s fireworks, in which mortgage giants Fannie Mae and Freddie Mac entered “conservatorship” status with the Federal Housing Finance Agency.

Like a ghost revived from horrors past, on September 11, 2017, the Justice department brought civil charges against Deutsche Bank mortgage bond trader Paul Mangione for fraudulently structuring sub-prime mortgage bonds back in April 2007, more than ten years ago. Mangione doesn’t face jail time, but rather civil penalties such as fines. So, we’re still reaping the consequences of the subprime mortgage debacle more than 10 years later, and still nobody’s going to jail.

My personal, deeply unpopular, view is that financial executives didn’t go to jail from the sub-prime mortgage crisis because they didn’t commit crimes. Poor money management is not a crime, nor is losing money for your firm or investors. Executives were guilty of believing too deeply in a flawed financial model or failing to respond quickly enough to systemic risks, but that’s a series of human errors, not jailable offences. Many observers of the sub-prime mortgage crisis disagree with me.

Jesse Eisinger, a Pulitzer Prize-winning financial journalist, just published a book this summer, called The Chickenshit Club: The Justice Department and Its Failure to Prosecute White-Collar Criminals, disagreeing with me. I mean, he’s not literally rebutting my argument, but rather he’s explaining the complex history of why nobody went to jail for the mortgage sub-prime crisis and the Great Recession more broadly.

As a general rule, I think it’s a tonic to learn from smarter, better-researched people who disagree completely with me. So I recommend the book whether you agree or disagree with me.

Eisinger’s answer to the question of “why no jail time?” as hinted at by his profane title, is that institutional weaknesses in the US justice system, from the SEC to the Justice Department to especially the Southern District of New York, made them unwilling and unable to catch white collar criminals and put them in jail.

Eisinger contrasts the earlier experience of the Enron prosecutions of criminal behavior by executives following the 2001 collapse of the trading giant with the absence of criminal prosecutions of Wall Street executives involved in the sub-prime mortgage collapse. So what changed between 2001 and 2008? In Eisinger’s telling, many factors combined.

First, a backlash developed against the damage caused by the aggressive prosecution of Enron’s accounting firm Arthur Anderson, a former “Big-5” accountancy, which drove them out of business in 2002.

Government prosecutors worried about the kind of collateral damage – to innocent employees, customers, investors – if they took down Wall Street firms, especially given how weak big firms were in the aftermath of 2008.

Second, prosecutors developed a preference for reaching a new kind of agreement called a “Deferred Prosecution Agreement,” (DPA) in which corporations – but importantly not individuals – agreed to pay fines as a result of bad actions. Typically a DPA meant a hefty corporate fine, ultimately paid by shareholders rather than executives, and an agreement to hire an outside monitor against future ongoing bad behavior.

Not incidentally, these monitoring agreements became extremely lucrative for big private law firms, encouraging a kind of Big Law lobby for more DPAs in place of criminal prosecutions.

Next, he describes a classic kind of regulatory revolving door between government prosecutors and lucrative white-collar defense practices. Eisinger believes many ambitious prosecutors want to eventually make ten times more money in private practice defending white collar criminals. So, they might not want to be overly aggressive prosecuting white collar criminals that could be their future private practice employers.

Finally, Eisinger describes prosecuting white collar crime as a particular skill, requiring a certain institutional culture of risk-taking and a consequences-be-damned attitude. Between the Enron/Arthur Anderson backlash and the rise of DPAs, our regulators lost their taste for putting executives behind bars. Running up the score with DPAs and corporate civil fines became easier than the more difficult task of jailing executives.

Interestingly, legal heavyweights making 2017 headlines such as James Comey, Preet Bharara, Eric Holder, Sally Yates, and Bob Mueller make cameos in Eisinger’s book, often in an unflattering, or at least mixed, context.

jesse_eisingerI spoke to Eisinger about his book recently. As a former mortgage and CDO salesman myself, I tried to explain, the actions of Wall Street folks described in civil complaints about sub-prime mortgage securitizations fell within a normal range of activity of how we did our jobs. Eisinger didn’t buy it.

But even reading the September 2017 civil suit about Paul Mangione at Deutsche Bank, I’m struck by how banal the complaint is. Mangione’s emails and phone records show he is deeply skeptical about the quality of mortgage underwriting standards. He neither created those mortgages nor had any real ability to influence their creation. His job was to take the product he received and try to make bonds he could sell out of them. To refuse to do that would be to refuse his way out of a job, at least a job as a sub-prime mortgage trader at Deutsche Bank.

I remain skeptical. Eisinger’s right to point out the troubling weaknesses in our current system of prosecuting white-collar criminals. I stick to my often unpopular stance that the sub-prime mortgage and CDO traders did not commit crimes for which they deserved jail.

 

a version of this ran in the San Antonio Express News and Houston Chronicle.

 

Please see related posts:

All Bankers Anonymous Book Reviews in One Place!

Mortgages Part VIII – The causes of the crisis

 

 

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Book Review – Zero Alternative by Luca Pesaro

Luca Pesaro’s Zero Alternative is a Dan Brown-style thriller, with a ruthless conspiracy of high-financiers chasing an ultra-effective prediction algorithm, a foreign-legion enforcer with a sadistic bent, a nihilistic hacker group, the chain-smoking derivatives-trading hero hoping to walk away from high finance after one last big trade, and a hot stripper who may or may not have a heart of gold (or maybe just shouldn’t be trusted.)

My favorite part of the novel may not be other people’s favorite. I particularly enjoyed the early chapters, tracking a tense morning of options trading and political infighting with our hero Scott Walker. The author traded options for a living. As a result, he doesn’t do hand-waving fake Wall Street-stuff with his trading descriptions. He has clearly sweated (and I assume chain-smoked through) these same P&L swings, the fights with managers, the adrenaline surge, the banter with subordinates, clients, and competitors.

With even a cursory knowledge of the finance world we recognize fictional stand-ins for Goldman Sachs,1 Wikileaks, Blackwater, George Soros,2 and the protagonist’s bank, which I’m going to guess is Deutsche Bank.3

Interestingly, since the driving element of Zero Alternative is a hunt for ultra-predictive-software, the novel’s plot predicts by a couple of years the market turmoil caused this Summer by Brexit. Both the author and the protagonist Scott Walter are Italian, so the EU-departing country is Italy, but the effect is the same. Pesaro and protagonist Walker share a few other biographical similarities, beyond nationality. They also went to the same high school.

zero_alternativeWhich makes this a good time to mention that Pesaro and I also went to high school together. I’m pretty sure we haven’t met up in 25 years, but our school The United World College of the American West – including the famous Montezuma Castle – makes an appearance in the crucial final fight scene of the novel. I’m guessing Pesaro hasn’t been on campus for 15 years, because he left the Castle in Zero Alternative in the unrenovated state of disrepair it was in when we attended the school, suitable only for forbidden late-night haunted-castle raids with headlamps and illegal bottles of hooch. Or maybe he has been back, and took literary license because it added to the spookiness of the scene.

Montezuma_Castle
The Castle, now renovated

Also interestingly, unbeknownst to me, Pesaro and I shared a kind of similar path. Like almost everyone from our school in that time – an idealistic, somewhat anti-capitalistic culture – we share mixed feelings about high finance. There’s the thrill and the attraction to it, including appreciating colleagues, adrenaline rushes, pay, meritocracy, and the essentiality of it all. But there’s also the sense that things can get off track systemically, as well as maybe a corruption at the level of the individual soul. I don’t think I’m reading too much into Luca’s novel to think he’d agree with that. In his acknowledgments page he thanks “all the good, weird and interesting people I’ve met through all my years in Finance – bankers are not all bad, believe me.”

At Bankers Anonymous, we believe you.

 

See related posts:

All Bankers Anonymous Book Reviews In One Place!

Book Review: Capital by John Lanchester

 

 

 

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  1. Hint: They’re the bad guys
  2. A kind of benevolent genius puppet-master
  3. Perhaps the author will let me know after he reads this review.

Book Review: Where Are The Customers’ Yachts by Fred Schwed

Sometimes I procrastinate reading something really important to the point that I want to kick myself. Over the years I’ve seen Where Are The Customer’s Yachts? By Fred Schwed listed on numerous ‘Best Of’ lists of financial books, but only now got around to it in 2016? Ugh, no excuse for me.

But don’t think of this as a financial book.

This is one of the best pieces of comedic writing I’ve ever read. Seriously.

Schwed’s voice at points reminds me of A.A.Milne, in that he begins with a banal-sounding truism, and then veers off – in the second part of his sentence – into an unexpected absurdity, unveiling a deeper truth. It’s not unlike my favorite faux-philosopher Jack Handey’s style, except Schwed’s actually somewhat useful, rather than just plain bonkers.

I say useful because we all need clever ways to defend ourselves against myths of Wall Street and its fawning handlers within the Financial Infotainment Industrial Complex. Schwed satirically punctures our deeply-held myths in a totally goofy way.

He published this in 1940, following his experience on Wall Street in the 1920s and 1930s, but you know what? Yes, you do know what. Plus ca change plus c’est la meme chose.[1]

The title, if you didn’t know, refers to an apocryphal story of a newbie visiting lower Manhattan who is shown all the bankers’ and brokers’ impressive yachts. Long before #FeelTheBern and Occupy Wall Street, Schwed’s retelling of the joke tapped into our suspicions about the inflated compensation of the financial industry.

 

So, read this for the hilarity, but understand that the sly truths slipped in there might just help us as well.

On market predictions

Schwed nails the point that Wall Street’s and the Financial Infotainment Industrial Complex’s predictions aren’t worth more than a printed almanac describing the weather over the next 365 days.[2]

I received a link from a friend genuinely concerned about this headline in the beginning of 2016: “Sell Everything! 2016 Will Be a Cataclysmic year, warns RBS”. It’s hard to explain just how useless these types of predictions really are, unless you’ve been inside the beast and can see these prophesies for what they are. Schwed has some hilarious stuff on this topic.

On Short-Selling

Back in the midst of the 2008 crisis short-selling became unpatriotic and in some limited cases (like naked-shorts) illegal. Popular aversion to short-selling clearly has a long history, as Schwed describes the early 20th Century views and blows up the mythology there as well.

On Options Trading

Schwed describes, tongue firmly in cheek, the possible mechanisms and joys of options trading. Helpfully, he follows that up with a few explanations of how puts and calls and straddles work, although mostly he describes the funny patter of options traders attempting to attract customers. If you’ve ever dealt with options traders (I have!) its pretty funny, and true.

We read useful other thoughts, couched in humorous self-deprecation. The author directly addresses why Schwed – by 1940 a former stock-broker and dabbler in stocks himself – isn’t wealthier.

In his own words:

“…[M]y tendency has been to buy stocks, all a-tremble as I do so. Then when they show a profit I sell them, exultantly. (But never within six months, of course. I’m no anarchist.) It seems to me at these moments that I have achieved life’s loveliest guerdon[3] – making some money without doing any work. Then a long time later it turns out that I should have just bought them, and thereafter I should have just sat on them like a fat, stupid peasant. A peasant, however, who is rich beyond his limited dreams of avarice.”

See, that’s what I’ve been trying to say all along.

That, and also, read his book.
customers'_yachts

Please see related posts:

All Bankers Anonymous Book Reviews In One Place

Never Sell! From Disney to Churchill

Mutual Funds v ETF

Talking One’s Book – Mistrust ‘The Experts’

 

[1] Important note: I have no idea what that means. As my close personal friend Steve Martin says, the French have a different word for practically everything.

[2] Every year a favorite restaurant-owner in my neighborhood hands out an annual paper calendar printed with exactly that: The upcoming weather for the next year, throughout the various regions of the United States. Every time I tear off the page of a new month, I take the time to read that months’ weather. For some reason the subtle humor of the The Liberty Bar calendar never gets old for me.

[3] I learned a word today!

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Michael Lewis Still Says It Better Than Anyone

Microphone-Trophy-psd86307When Bankers Anonymous hands out its annual awards for the best “recovering banker” essays of the year, the black tie crowd typically goes on chattering amongst themselves, unheeding the speaker at the stage holding the golden microphone trophies.

Why? Becuase they know that Michael Lewis will win the best essay trophy once again. Like clockwork. It’s so unfair.

If you’re at all sympathetic to what I’ve been trying to do for the past few years then – like those unheeding black-tie guests – you’ll not be surprised in the least that I’ve linked to his article in Bloomberg again, lamenting the Occupational Hazards of Working On Wall Street. Read this, its good.

Damn him for taking the trophy again this year.

Michael-Lewis

Please see related posts:

Michael Lewis reviewing John Lanchester’s Capital

Michael Lewis’ Liar’s Poker

Michael Lewis’ The Big Short

Michael Lewis’ Boomerang

Michael Lewis’ Flash Boys

 

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Book Review: Flash Boys by Michael Lewis

The Rise of the Machines

Michael Lewis wrote Flash Boys to alert the non-finance world about the scourge of high frequency traders front-running investors and fracturing traditional capital markets.

Lewis does not distinguish between quantitative (or algorithmic) trading strategies and high frequency trading firms (HFTs), although it’s helpful to define these terms first.

Quantitative strategies – of which HFTs form a subset – are computer-driven trading models, in which the human input all occurs prior to a market’s opening bell. The human instructions come from computer programmers who tell the model to look for certain signals in the way securities trade to prompt a buy or sell order. HFTs are a type of quantitative strategy that rely on speed, in milliseconds, to successfully execute trades. A good primer generally on quant trading and HFTs from someone inside that world is Rishi Narang’s Inside The Black Box, which I reviewed recently.

Lewis points to at least four simultaneous innovations that have led to the profitable opportunity for high frequency trading firms over the past decade.

  • First, an investor-protection law from 2005 called Reg NMS demanded that investors receive the ‘best’ price visible on a stock exchange, even though sophisticated investors know that large investment purchases or sales may get a best overall price if done quietly ‘off-market’ without alerting the rest of the investment community. Following Reg NMS, HFTs can play games with the ‘visible’ market price by posting, say, 100 shares for purchase or sale, only to cancel that price as soon as a real order hits the market. In Lewis’ telling, the 100 share order from the HFTs becomes an electronic trip-wire to signal certain types of large investors are making a move, and allowing the HFTs to front-run that investor through superior trading speed.
  • Second, the fracturing of the equity markets into more than a dozen major electronic exchanges and 40 (or so) broker-dealer created ‘dark pools’ for anonymous electronic trading has created multiple opportunities for risk-less arbitrage between exchanges, for those HFTs who execute trades in milliseconds.
  • Third, the privatization of US stock exchanges like the Nasdaq and New York Stock Exchange led the exchanges to seek their own profit through fee arrangements with HFTs at the expense of investor-oriented protections, which would have limited the access of HFTs.
  • Fourth, technology – between lightning-fast software and speed-of-light fiber optic cable – created a haves and haves-not unfair playing field between investors in many markets.

Lewis’ narrative follows the evolution of his protagonist Brad Katsuyama who figures out just enough of the HFT game to become inspired to shut it down – first because it interferes with his job trading equities for the Royal Bank of Canada, and later because he’s a self-appointed evangelist for protecting real investors from the HFTs.

Bill Murray

Katsuyama and his plucky rag-tag group of Wall Street castoffs – and here Flash Boys most closely resembles the plot of every early Bill Murray movie like Meatballs and Stripes – set out to build a better exchange known as the Investors Exchange (IEX),[1] which through slow trading will box out the HFTs and their nasty algorithms.

 

The moralistic tone, and why it matters

Flash Boys differs from Lewis’ earlier finance books in the introduction of his moralistic tone – he seems genuinely outraged by the activities of high frequency trading firms. This moral outrage differs from the way that he was previously mostly amused by disgusting mortgage traders, stupid Icelandic Viking financiers, or Sub-prime CDO structurers.

In Liar’s Poker, Boomerang, and The Big Short Lewis distinguished himself from other financial journalists by adopting a knowing attitude toward Wall Street’s greedy ways. Whereas other financial journos portray a fairy tale world of virtuous small-time investors and evil greedy bullies, Lewis worked on Wall Street for a few years and knew better than to fall into that trap.

Lewis usually celebrates – at least up to a certain extent – those who outwit the competition to earn themselves a big payout.

Lewis’ bad guys in those earlier tales typically would receive a kind of satirical treatment for their excessive attitudes. Lewis found ways to laugh at his antagonists because he spent time enough with them to understand their strengths, weaknesses, and the right distinguishing characteristic to turn their unattractiveness into humor.

Lewis does not seem to have spent any time getting to know high frequency traders for Flash Boys, however, and here his moral tone – rather than knowing satire -exposes a weakness.

I’m not saying Lewis shouldn’t be upset about high frequency trading. He makes a compelling case that we should all take a much harder look at whether all of their activity acts like a massive, hidden, tax on capital markets. What I am saying is that the moral tone – which resembles the style of weaker financial journalists – exposes the fact that he hasn’t spent enough time getting to know actual high frequency traders.

flash_boys

If he had spent time with some, we would have gotten some funny anecdotes and satirical send-ups – That Russian programmer with the bad breath and an unhealthy obsession with Miley Cyrus! Ha! The South African technologist who keeps twenty cats in his office and eats only vegetables that start with the letter T! You can’t believe how funny these guys are! That kind of thing.

The humor is amusing in its own right of course, but the humor also tells us that Lewis was there, and got to know these people. Unique among journalists he has a track record of actually going out and finding the stories rather than create fairy tales based on preconceived moral views. The Good Guys = Brad Katsuyama & Team versus Bad Guys = Faceless & Nameless HFTs formula makes me suspect we only got a portion of the full story.

I’m thinking about Lewis’ apparent failure to talk to HFT folks because a friend of mine from the HFT industry thinks Lewis totally blew it when describing his world.

I do not know HFTs myself well enough to judge, but I know my friend has a moral compass and wants the HFT story portrayed accurately.

(And you should see his 20 cats! Just kidding.)

I’m hoping in coming weeks to learn enough to judge better the accuracy of Flash Boys. More importantly than judging the book, I’d like to know to what extend HFTs really threaten the system, as Lewis argues.

More questions than answers

For my own future reference, but also perhaps other readers, here’s my beginning list of further questions to explore and answer after reading Flash Boys.

rise_of_the_machines
We have got to stop SkyNet
  1. Lewis leaves practically unanswered what I think is the much greater problem of quantitative and high frequency trading: As computer algorithms constitutes 50-80% of all trading volume on US exchanges, what are we doing to shore up the system against massive technical fails like the Flash Crash of 2010, or like the Crash of ’87, for that matter? We haven’t seen The Big One yet but I’m pretty worried about it, and I hope regulators have a plan in place to prevent it. In other words, WE MUST PREVENT SKYNET! WHERE IS OUR JOHN CONNOR?
  2. If Katsuyama’s IEX is a better mousetrap and a solid protection against HFT front-running, as Lewis believes, how has it fared in the subsequent months since opening in October 2013? I’ll be curious to know if it has begun to siphon off volume from other exchanges and the broker-created dark pools. If investors are self-interested, they should want to participate in the IEX far more than the shark-infested dark pools.
  3. Lewis mentions only two HFT strategies that I can see, in simplest form: Strategy #1: Set up 100 share trip-wires inside these exchanges. When those get tripped, quickly front-run the direction of the market ahead of a big order. Strategy #2: Gain arbitrage opportunities by seeing an order in one exchange and then quickly executing in another exchange based on that order. Strategy #1 is borderline illegal so it strikes me as something that regulators could address. Strategy #2 is theoretically (marginally) ‘creating efficiencies,’ although not if the HFTs are, as they seem to be doing, seeing order flow to some exchanges faster than everyone else. IEX could put that strategy #2 out of business. But something tells me there are many dozens to hundreds more HFT strategies not described in this book. What are they?
  4. Whatever happened to the high-speed line built by Spread Networks from New Jersey to Chicago mentioned in the early chapters? And was it made obsolete by the microwave towers mentioned in the Epilogue, or is that part of the same network?
  5. My friend from the HFT firm mentioned this one to me: Lewis relays a very fishy anecdote about a hedge fund trader typing a buy order into his computer, only to watch the market suddenly shift away from him before he hits enter to execute the trade. This is, basically, impossible – unless the HFTs have hacked into the hedge fund guy’s computer – to see his trades before he even sends them to the exchange. Even I’m not that paranoid about Skynet yet. So, Lewis, what’s up with that anecdote?
  6. Can we, and should we, distinguish between quantitative trading – relying on computer algorithms rather than human input to execute trades – and HFTs in a meaningful way when it comes to regulation and treatment in a market exchange?

 

That’s my short list of questions. More to come later.

Please see related posts:

Book Review of Pete Kovac’s Flash Boys: Not So Fast

Book Review of Rishi Narang’s Inside The Black Box

Book Reviews of Michael Lewis’ previous books on finance:

Liar’s Poker

Boomerang

The Big Short

Crashes happen when quants take over the markets, in Rise of The Machines

 

 

[1] Fun fact: They didn’t use the full URL of the exchange name because, you know, investorsexchange.com could be interpreted a variety of ways.

 

 

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